A Breakdown of the UK's Inflation Rate

Several months ago, we reported that since July 2018, Britain’s Consumer Price Index (*CPI) has been edging downwards. Over that period the rate has fallen from 2.7% to 2.1%. Pleasingly, this downward trend has continued. Earlier this week, data released from the Office for National Statistics showed the inflation rate dropping below the Bank of England’s 2% target, the first time in two years, to 1.8%.

*CPI reflects the weighted average of prices on a basket of consumer goods and services that is used as a measurement tool for inflation.

Moderate inflation within an economy is not unwelcome. Most central banks set a positive target for inflation indicating they believe rising price levels are necessary. Why? For one thing inflation incentivises spending now rather than later which, in turn, drives economic growth. Of course, this is all very well in the short run, but it is unfavourable in the longer-term. Reconciling this is tricky so economists tell us that inflation is okay provided it is in moderation and anticipated. Hence, central banks set a target around which businesses and individuals can plan.

Whilst low and stable inflation is desirable for consumers, extreme deviations beyond this are unwelcome. For example;

a) deflation, where prices fall in aggregate, or conversely;

b) hyper-inflation, a phenomenon where prices spiral out of control, as currently seen in Venezuela.

Economists have determined that the reason behind the current decline in inflation is lower energy prices. Household energy inflation fell from 8.1% to 1.4% following the Office of Gas and Electricity’s (Ofgem) newly introduced price cap. Lower oil prices are also helping subdue inflation. These factors alone reduced the CPI figure by 0.3%.

What does a lower inflation figure mean for individuals?

In November, average wage growth rose to 3.3%. If maintained at the same rate, real wage growth (the difference between wages and inflation) will rise to 1.5% producing the largest divergence since 2016. What happens thereafter is all about confidence. If people feel worried they may save the difference but, if confident, they may spend and even borrow more giving an uplift to GDP growth through higher consumption.

Inflation Rate vs Wage Growth

Source: Bloomberg, February 2019

The UK economy along with other countries, has seen its economic rate of growth slackening. There are many factors, including weaker global trends and lower consumer confidence behind this slowdown. However, unemployment in the UK and across other developed economies is low and falling. If this continues even better wage growth prospects lie ahead, thus potentially improving real wage growth further.

Unemployment Rate

Source: Bloomberg, February 2019

Inflation is rarely constant, and the dip may well be short lived with recent, helpful, factors receding. For example, Ofgem have announced that the price cap on energy prices will be reversed in April and world oil prices could easily rebound. Food price inflation can also be affected by seasonal trends and there are many other influences that can impact price increases. The Bank of England has forecast the inflation rate to rise slightly, going back up to between 1.9%-2.1%. If correct, they are expecting inflation to stick very close to their target rate.

Low and stable inflation is highly desirable and if economic momentum and confidence builds, expect moderate rises in interest rates to follow, gently, over time.

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